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Friday, November 9, 2012

Casey Mulligan Nails It

To put it another way: for every worker that construction lost between 2007 and 2010, the rest of the economy lost at least another five workers, rather than gaining workers. I agree with Professor Krugman and other opponents of the “sectoral shifts theory” that something must have happened — in less than a year or two — that profoundly affected practically all industries and practically every region.

Mulligan is right that something suddenly happened that affected economic activity in every region and every industry. I date this development to about mid-2008 as can be seen in the following figures. The first one shows that despite the start of the housing recession in April, 2006 employment in the rest of the economy continued to grow through early 2008:

Similarly, despite the fall in dollar incomes tied to housing, other dollar incomes continued to grow until about mid-2008:

So, as Mulligan notes, something turned a two-year sectoral recession into an economy-wide one. Many folks attribute it to the worsening of the financial crisis. I think a better story is that the Fed passively tightened monetary policy around mid-2008. A passive tightening occurs whenever the Fed allows total current dollar spending
to fall, either through a endogenous fall in the money supply or through
an unchecked decrease in velocity. Given a proper measure of the money stock--one that includes both retail and institutional money assets--this can be shownto be the case for the U.S. economy during this time. This reduction in broad money assets and the drop in velocity amounts to an excess money demand (i.e. safe asset shortage) problem.

The Fed's failure to stabilize total dollar spending had implications for household balance sheets. Households had come to expect about 5% annual nominal income growth over the past 25 years or so. These expectations were assumed by household and firms when they signed long-term nominal fixed debt
contracts. A debt crisis was therefore
inevitable when these long-term nominal income forecasts were not realized.

Now Casey Mulligan thinks it was a change labor market incentives brought on by government policies that caused the economy-wide collapse. I agree with Mulligan's premise that these policies do change incentives, but am not convinced that magnitudes are large enough to explain the severity of the past four years. A far easier story to tell is there has been an excess demand for money assets (i.e. a shortage of safe assets). For households this is a particularly compelling story:

Here's hoping that Mulligan, who has done extensive work on money demand, can weave this story into his narrative of the crisis.

12 comments:

So Mulligan nails it, in so far as he agrees with Krugman, then largely goes off the rails.

I really think the Great Vacation Theory is indefensible. You have to believe that people prefer UI to a paycheck, and that is a sufficient incentive to forgo not only more money in both the short and long runs, but also the stability and financial security of employment, and the dignity of work.

Plus, for a while there, jobs were being eliminated and nobody was hiring. It's not as if workers were controlling their own employment destinies. Doesn't that matter?

In all due respect, perhaps you ought to reconsider this post's title.

Jazzbumpa, cheers to you too! So my qualifier on the first line is good enough for you? Look, we may disagree with Mulligan on the importance of the labor market incentive story, but we should at least acknowledge that he sees something--the suddent drop in aggregate economic activity--that can't be explained by a sector reallocation story. Many folks don't get that far. And hopefully this post will encourage him to consider a tight money story too.

OK - I glossed over the first line. However, in the middle you also say "I think a better story is . . ." But let's not get hung up on that.

I'm more interested in the passive tightening FED scenario. But that looks quite different if you chose a different measure. Here are MZM and MZM velocity.

http://research.stlouisfed.org/fred2/graph/?g=cHq

MZM sagged a bit, but not until after the recession bar on the FRED graph. Velocity has been in secular decline for 30 years with lower highs and lower lows almost exclusively over that time. Without the grey bar, there is no way you would suspect a 2008 recession just from the data curves.

I also wonder about households expecting 5% annual nominal income growth. This must be a total-society aggregate number. I don't believe it can possibly be the case for the bottom 47%.

Can any of what happened be explained by a demand shortfall due to a large segment of the population having too much personal debt and not enough income?

MZM is largely retail money assets so it ignores most institutional money assets. With that said, if you look at the components of MZM, the one that has grown the most it is saving deposits, the highest yield FDIC-protected asset. Other assets not protected by FDIC have fallen over this period. I see this as evidence of increased demand for safe assets, at least by households. (http://research.stlouisfed.org/fred2/graph/?g=cHK)

The figure linked to above that shows household's expected income is the average of household responses from the Michigan Consumer Sentiment survey. The median version of this shows about 2% prior to the crisis. But it also shows a sharp fall that has yet to recover, so it tells the same story just with different magnitudes.

Re: the Sentiment Survey, For the mean to be 4-5% and the median to be ca. 2% is a huge difference. And the 47% are all below median.

Yes it tells a parallel story, but it also tells an additional story of a large segment of the population with very rational low expectations.

I have to believe that putting more money in the hands of these people - where it will be quickly spent on necessities - is more effective stimulus than even very large changes in money supply, per se.

I'm not familiar with Mulligan's work on money-demand. What I've read of him on the internet seems to focus just on microeconomics, minimizing the importance of macro topics like that (and arguing the Fed doesn't have much impact).

TGGP, Mulligan's work on money demand is limited (as far as I can tell) to traditional measures of money like M2. Maybe he does not see that what is money has expanded beyond those assets. I am hoping this post gives him a chance to think about this possibility.

Anonymous, cheer up. If you actually follow the above links to the money asset data you will see this is not "argument by assertion." Also check out my paper with Josh Hendrickson titled Transaction Asset Shortages where we formally develop some of the points and provide further empirical evidence on the shortage of safe asset problem.

This notion is original. See Willam A. Barnett's book or Gary Gorton's work on the Shadow Banking system.